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Lukoil
(Russia)
4.800%
3.000%
5.700%
13.500%
Beta (relevered)
Cost of equity
0.87
18.981%
1.04
18.840%
Cost of Debt
Tax rate
Cost of debt, after-tax
8.400%
28.000%
6.048%
6.800%
28.000%
4.896%
Debt/Capital ratio
Equity/Capital ratio
33.300%
66.700%
47.000%
53.000%
WACC (calculated)
14.674%
12.286%
14.700%
12.300%
This approach applies the sovereign risk premium to the cost of equity for both companies,
but not to their cost of debt. Since the comparison is for two oil companies from two
different countries, and the same risk free rate is used for both, it is implied, though not
stated, that the WACC calculation is based in US dollars.
Source: "Petrobras: A Diamond in the Rough," JP Morgan, Latin American Equity Research, June 18,
2004, p. 24.
2004
4.500%
0.99
6.000%
5.500%
15.940%
Exchange Rate
Cost of equity (R$)
2.000%
18.259%
Cost of Debt
Tax rate
Cost of debt, after-tax (R$)
8.600%
34.000%
5.676%
Debt/Capital ratio
Equity/Capital ratio
40.000%
60.000%
13.23%
13.20%
This calculation adds the country risk premium to the risk free rate in the cost of
equity, but not the cost of debt (as was the case in the previous problem). This cost
of equity in US$, however, is then compounded by a percentage change in the
expected exchange rate of the reais against the dollar to arrive at a cost of equity in
reais. The cost of debt, which indicates reais-denomination, is not adjusted for the
country risk premium or the expected currency movement.
2004E
9.400%
1.09
5.500%
15.395%
March 8, 2005
2003A
9.000%
1.08
5.500%
14.940%
2004E
9.000%
1.10
5.500%
15.050%
Cost of debt
Tax rate
Cost of debt, after-tax
8.400%
28.500%
6.006%
8.400%
27.100%
6.124%
9.000%
28.500%
6.435%
9.000%
27.100%
6.561%
Debt/capital ratio
Equity/capital ratio
32.700%
67.300%
32.400%
67.600%
32.700%
67.300%
32.400%
67.600%
WACC
12.20%
12.30%
12.10%
12.30%
WACC (calculated)
12.25%
12.39%
12.16%
12.30%
This approach uses a relatively high assumed value for the risk free rate of interest in the cost of equity calculation, without
expressly charging the company a country risk premium. Since the U.S. dollar risk-free rate at this time was somewhere around
4%, this risk-free rate must implicitly include a country risk premium. The cost of debt, before-tax, is actually below the riskfree rate, which is difficult to understand or rationalize.
Source: "Petrobras," Citigroup SmithBarney, March 8, 2005, and July 28, 2005.
June 2003
9.90%
1.40
5.50%
17.60%
10.00%
34.00%
6.60%
6.60%
50.60%
17.60%
49.40%
12.00%
WACC (calculated)
12.03%
Identifying the risk-free rate as the Braizilian C-Bond rate, and using a relatively
high value of beta compared to other analyst estimates, the cost of equity is
relatively high. The cost of debt, also high compared to the other estimates,
results in a final WACC calculation, in Brazilian reais, which is similar in value
to other estimates.
Source: "Petroleo Brasileiro S.A.,Citigroup Smith Barney, June 17, 2003, p.17.
2003 Estimate
4.10%
6.00%
-1.00%
9.10%
2004 Estimate
4.40%
4.00%
-1.00%
7.40%
9.10%
0.80
6.00%
13.90%
2.50%
16.75%
7.40%
0.80
6.00%
12.20%
2.00%
14.44%
8.50%
35.00%
5.53%
8.50%
35.00%
5.53%
5.53%
31.00%
16.75%
69.00%
5.53%
28.00%
14.44%
72.00%
WACC (calculated)
13.27%
11.95%
13.30%
12.00%
2
3
This analysis clearly begins with a U.S. dollar-based risk-free rate, 4.1% and 4.4%, adds a country risk premium
to it, and then adjusts the sum downward for a Petrobras premium. The Petrobras premium is the analyst's
opinion that Petrobras is an oil and gas company, and therefore operates in a global dollar market which is in
many ways less risky than a pure-play on a Brazilian firm. The resulting cost of equity is then converted from
reais to dollars with the application of a currency devaluation multiplier, a stated average expectation for the
coming decade.The cost of debt assumed is very low -- 5.53% -- which is clearly a dollar cost and not a reais
cost as stated. The final WACC in reais terms is roughly equivalent to the various estimates from the previous
problems.
Notes:
1 Petrobras premium adjustment is the reduction in country risk given an oil and gas company operating in a global industry
which operates in a market of US dollar denominated returns.
2 Cost of equity in US$ = risk free rate + ( beta x market risk premium )
3 Cost of equity in R$ = [ (1 + cost of equity in US$) x (1 + projected devaluation) ] - 1
Source: "Petrobras," BBVA Securities, Latin American Research, December 20, 2004, p. 7.
Exchange Rate
Cost of equity (R$)
UNIBANCO
(Aug 12, 2004)
4.500%
5.500%
0.000%
10.000%
0.99
6.000%
15.940%
BBVA
(Dec 20, 2004)
4.400%
4.000%
-1.000%
7.400%
0.80
6.000%
12.200%
2.000%
18.259%
0.000%
17.600%
2.000%
14.444%
Cost of Debt
Tax rate
Cost of debt, after-tax
8.400%
28.000%
6.048%
8.400%
27.100%
6.124%
8.600%
34.000%
5.676%
10.000%
34.000%
6.600%
8.500%
35.000%
5.525%
Debt/Capital ratio
Equity/Capital ratio
33.300%
66.700%
32.400%
67.600%
40.000%
60.000%
50.600%
49.400%
28.000%
72.000%
WACC (calculated)
14.7%
12.4%
13.2%
12.0%
11.9%
14.7%
12.3%
13.2%
12.0%
12.0%
$
$
a) Depreciating
5,000,000
7.375%
2.0260
1.9460
b) Appreciating
5,000,000
7.375%
2.0260
2.1640
5,000,000.00
368,750.00
5,368,750.00
5,000,000.00
368,750.00
5,368,750.00
10,447,587.50
10,130,000.00
$
$
11,617,975.00
10,130,000.00
1.03135
1.00000
0.03135
1.14689
1.00000
0.14689
3.135%
14.689%
Value
80,000,000
6.250%
1.3460
-3.000%
Year 0
Year 1
Year 2
Year 3
- 5,000,000
- 5,000,000
- 5,000,000
- 5,000,000
- 5,000,000
- 80,000,000
- 85,000,000
80,000,000
80,000,000
6.250%
1.3460 $
1.3056 $
1.2665 $
1.2285
107,680,000 $
(6,528,100) $
(6,332,257) $
(104,418,918)
3.063%
The internal rate of return, IRR, of any stream of cash flows will determine the rate of discount (interest) which results in a NPV
of the cash flow stream of exactly zero.
Component
25 year US dollar bonds
5 year US dollar euronotes
10 year euro bonds
20 year yen bonds
Shareholders' equity
Total
Value
30.00%
6,000,000
750,000,000
1.2400
1.8600
109.00
US Dollar
Amount
10,000,000
4,000,000
7,440,000
6,880,734
50,000,000
78,320,734
Proportion
12.77%
5.11%
9.50%
8.79%
63.84%
100.00%
Pre-tax
Cost (%)
6.000%
4.000%
5.000%
2.000%
20.000%
Post-tax
Cost (%)
4.200%
2.800%
3.500%
1.400%
20.000%
WACC =
Weighted
Component
Cost (%)
0.5363%
0.1430%
0.3325%
0.1230%
12.7680%
13.9027%
The component coupon costs (for example the 6% coupon on the 25-year US dollar bonds) are the same as the current yields to maturity that would be
needed to sell similar bonds in the marketplace today. Current yields to maturity is the proper rate to use. The interest costs used for the euro and yen
bonds reflect actual expected interest costs after any exchange rate changes. This calculation assumes there is no expected change in the exchange rate
over the life of the debt issue (which is indeed highly unlikely).
a. Sell Japanese yen bonds at par yielding 3% per annum. The current exchange rate is 106/$, and the yen is expected to strengthen against the dollar by 2% per annum.
b. Sell euro-denominated bonds at par yielding 7% per annum. The current exchange rate is $1.1960/, and the euro is expected to weaken against the dollar by 2% per annum.
c. Sell U.S. dollar bonds at par yielding 5% per annum.
Which course of action do you recommend Grupo Modelo take and why?
Alternatives
Coupon rate
Current spot rate, yen/$
Expected change in the value of the foreign currency
Principal needed by Grupo Modelo
Japanese
yen bonds
3.000%
106.00 $
2.000%
100,000,000
Year 0
euro
bonds
7.000%
1.1960
-2.000%
US dollar
bonds
5.000%
Year 1
Year 2
0.000%
Year 3
Year 4
10,600,000,000
106.00
100,000,000 $
5.060%
(318,000,000)
103.92
(3,060,000) $
(318,000,000)
101.88
(3,121,200) $
(318,000,000)
99.89
(3,183,624) $
(10,918,000,000)
97.93
(111,490,512)
83,612,040
1.1960
100,000,000 $
4.860%
- 5,852,843
1.1721
(6,860,000) $
- 5,852,843
1.1486
(6,722,800) $
- 5,852,843
1.1257
(6,588,344) $
- 89,464,883
1.1032
(98,693,393)
100,000,000 $
5.000%
(5,000,000) $
(5,000,000) $
(5,000,000) $
(105,000,000)
Given the expected exchange rate changes, the euro-denominated bonds have the lowest all-in-cost of funds for the Mexico-based company, Grupo Modelo.
(Note that it is the expected changes in exchange rates which determine this outcome. In the event that all currencies were expected to remain fixed, an expected
change of 0%, then the Japanese yen bonds are clearly the cheapest source of capital.)
Value
650,000,000
1.20%
Interest Costs
LIBOR
Spread over LIBOR
Total interest cost
Calculation of the effective cost of funds
Face value of syndicated loan
less fees for issuance
Net proceeds of syndicated loan
Interest payment due at end of 6-month period
(annual rate divided by 2 for 6-month period)
Total interest payments in first year of loan
Effective interest cost (interest payment/proceeds)
$
$
Issuance
650,000,000
(7,800,000)
642,200,000
$
(53,950,000)
8.401%
First 6-months
8.000%
0.800%
8.800%
2nd 6-months
7.000%
0.800%
7.800%
First 6-months
2nd 6-months
(28,600,000)
(25,350,000)
Value
11,400,000
15,200,000
20,000,000
60,000,000
$
$
$
$
$
4,000,000
6,000,000
12,000,000
5,000,000
20,000,000
3.80
10.00
Value
Percent
3,000,000
2,000,000
12,000,000
17,000,000
40.48%
25,000,000
59.52%
Total capital
42,000,000
100.00%
Note that the equity accounts of the subsidiaries are matched by "investment in subsidiaries" asset account held
in the non-consolidated books of the parent company. In consolidation these two accounts cancel each other out.
Value
5,000,000
7.250%
5,000,000
7.000%
7.8000
39,000,000
41,730,000
5,362,500
7.7818
Value
1,000.00
8.00%
4.00%
Days Since
Previous Date
Cumultive Days
From Start
122
180
180
180
180
62
122
302
482
662
842
904
904
Cash Flows
(par x coupon x
days/180)
$
$
$
$
$
$
$
27.11
40.00
40.00
40.00
40.00
13.78
1,000.00
1.0269
1.0680
1.1107
1.1552
1.2014
1.2177
1.2177
Note: That the reason these Euro Medium Term Notes each have a market value which exceeds their face value is because the first coupon is paid sooner than the
six month period separating coupon payments. For example, if all coupons payments were made in 180 days increments ("days since previous date"), the
market value of notes would be at the par value of $1,000.
Discounted
Cash Flows
(US dollars)
$
$
$
$
$
$
$
$
26.40
37.45
36.01
34.63
33.30
11.31
821.21
1,000.31
Proceeds of issuance
Face value
Discount rate (1 + ((days/360) x (ytm)))
Proceeds equal (Face value / Discount rate)
Value
2,000,000
60
6.000%
Value
$
$
2,000,000.00
1.01000
1,980,198.02